Turkey’s High Yields Tempt Investors

Turkey’s central bank packs a punch when it comes to attracting investors with high yields, even after a surprisingly large cut to a key interest rate.

The latest evidence: a lira rally and dropping bond yields following the central bank’s decision on Tuesday to reduce the ceiling of its interest rate corridor to 10% from 11.5%, leaving the lower end unchanged at 5%. Economist had forecast a maximum reduction to the tune of 1 percentage point.

Governor Erdem Basci’s move is part of an ongoing balancing act whereby the central bank is pursuing numerous, and sometimes conflicting, tasks.

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While fighting inflation and supporting the currency have been at the forefront of the Ankara-based lender’s monetary policies, the central bank is becoming increasingly concerned about Turkey’s slowing economy and bowing to government demands to loosen its stance, analysts say.

That’s why the central bank sent a strong signal that borrowing costs will continue to decline. And, that’s also why the lender showed international investors that it won’t shy away from raising funding rates to support the lira if risk appetite sours.

Indeed, Mr. Basci has tightened the central bank’s stance six times since introducing his unorthodox policy mix in October, when the governor started setting funding costs daily under its so-called interest rate corridor, rendering official rates irrelevant. In January, average funding costs for commercial banks reached a peak at 11.9%, when Mr. Basci withheld cheap lending. See-sawing widely during the first half of the year, it has started falling steadily in June and dropped to 6.1% this week.

“Among emerging markets, Turkey offers the highest yield in an environment of declining interest rates. Its closest competitor for international cash flows, Russia, has a benchmark rate of 8.25%, which means that there’s still quite a lot of room for Turkey’s central bank to reduce the ceiling of its interest-rate corridor,” said Selim Cakir, chief economist at Turk Ekonomi Bankasi AS in Istanbul.

At the same time, the central bank’s ability to sow trust among investors also depends on the rates corridor.

“The narrowing of the band decreases Turkey’s flexibility to defend the lira against an attack because its net reserves aren’t huge, hence the strength of its rates weapon depends on the wideness of the corridor,” Mr. Cakir said.

Some economists say Mr. Basci is likely to reduce the overnight lending rate to 9% by year-end, restoring it to the level it was at before the central bank had to hike funding costs in October to prop up the lira, which plummeted about 20% against the dollar last year.

However, if you ask Economy Minister Zafer Caglayan, who has been calling for rate cuts since July, the governor is already late to the party.

“There could have been a cut slightly earlier…. From now on, we expect there to be some more cuts to the market rates,” Mr. Caglayan said in a statement after the central bank’s decision. “Turkey needs growth.”

Yet after the central bank stepped on the brakes and hiked rates last year in an effort to help rebalance Turkey’s economy by curbing credit-fueled domestic spending, the high growth rates of the past two years became fleeting.

Gross domestic product expanded by 3.3% in the first three months and growth slowed to 2.9% in the second quarter. Initial data for the period that will end in September signals a further weakening in business activity. That contrasts with an 8.5% annual growth rate last year. Some ministers and most economists now say the government is unlikely to meet its 4% economic expansion target for this year.

And while the central bank’s policies are aligning with the government and becoming more growth oriented, Governor Basci still refuses to give up on his “flexible” policy tools.

“With the 150 basis-point cut, expect the lira loan rates to come down in the coming weeks, supporting the loan growth and the domestic demand in the fourth quarter of 2012,” said Turker Hamzaoglu, a London-based economist at Bank of America Merrill Lynch, adding that he expects the macro rebalancing to have peaked.

After cutting the effective funding rate to 6.1% as of this week from 10.2% in June, Mr. Basci started tweaking reserve requirements, which the governor is using actively as he eyes the third round of quantitative easing by the Federal Reserve and the European Central Bank. Economists say the amount of money flowing into Turkey in search of high-yielding assets will increase on the back of additional monetary easing in the U.S. and Europe.

To fend off destabilizing effects of hot money flows and strengthen its foreign currency reserves, the governor increased the amount of gold, dollars and euros that lenders must deposit with the central bank to free up lira reserve requirements.

It did so by using another unique policy tool that it employs to deal with the inflow of short-term deposits and their effects on the lira. This reserve option coefficients, or ROC, requires commercial banks to deposit proportionally more foreign currency at the central bank if they want to convert more lira reserves into foreign currency or gold. Turkish banks are keeping more than 90% of their reserve requirements for lira deposits in foreign exchange and gold because they provide cheaper funding than the local currency.

At Wednesday’s meeting the central bank tightened reserve requirements by increasing the ROC, which should increase the central bank’s foreign reserves by about $3.6 billion and at the same time free up lira liquidity.

“Raising ROCs corresponds to slightly tighter monetary stance for the banks, yet this impact is more than offset by the recent sharp decline in the funding cost and the narrowed corridor,” said Nilufer Sezgin, chief economist at brokerage Ekspres Invest in Istanbul. “The central bank may be proactively attaching a higher chance to acceleration of capital inflows on the back of the Fed’s additional monetary easing.”

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Emerging Europe Real Time provides sharp analysis and insight into what’s making news in Central and Eastern Europe. Drawing on the expertise of our reporters in the Czech Republic, Hungary, Poland, Russia and Turkey, the site provides an inside track on economics, politics and business in this emerging part of the European continent.